​​There are books full of different ways to categorize, screen, and evaluate a good investment, but instead of theories they are called strategies. For example, LBW would be considered a “value” investor because we implement a “value” investing strategy[1]. There are many other strategies such as growth, passive, strategic allocation, dynamic allocation, market neutral, etc. – you get our point. One strategy that has become a hot topic in recent years is Sustainable, Responsible, and Impact investing (SRI). For this month’s blog, we would like to take a dive into what SRI is, how it is categorized, and our general thoughts on this type of strategy.

History of SRI…This thought process seems to be new, but it has been around for ages. For example, during the biblical times Jewish law laid down directives about investing ethically. The Qur’an and Islamic teachings include guidelines for Hala or Shariah-compliant investing that focus on moral values and require investors avoid some types of investments and even interests.[2] Furthermore, in 1758 the Religious Society of Friends (Quakers) in their Philadelphia Yearly Meeting prohibited members from participating in the slave trade[3]. Fast-forward to today, and as of year-end 2015, more than one out of every five dollars under professional management in the United States was invested according to SRI strategies[4].

What is SRI investing? SRI can be defined as “an investment discipline that considers environmental, social and corporate governance (ESG) criteria to generate long-term competitive financial returns and positive societal impact.”[5] Said differently, when an investor is looking for investment opportunities they want to make a dollar and some form of social return. Traditionally speaking, when investors are looking for opportunities they typically look to generate the highest return with the least amount of risk. To do so, they evaluate an investment’s fundamental characteristics such as its business model, financial health, and corporate governance. Economist Milton Freidman’s article titled “The Social Responsibility of Business is to Increase Profits”[6] sums up this thought quite nicely – social responsibility typically isn’t in the cards. Instead, SRI attempts to find opportunities which exude potential financial gain and have the possibility of positive societal impact.

Types of SRI strategies and its criteria…SRI investing has many names depending on the type of strategy and criteria an investor uses. For example, if a fund is more driven towards environmental issues and impact, their strategy may be coined “green investing”. Or, if a fund is geared more towards companies that provide equal pay and have strong governance around these issues, their strategy may be called “ethical investing”. If you boil all of this down, two fundamental strategies emerge: 1) ESG incorporation into the investing process; and 2) filing shareholder resolutions and practicing other forms of shareholder engagement[7].​ESG incorporation…As stated above, ESG stands for “environmental, social, and corporate governance”. Meaning, to implement an SRI strategy you must be using criteria that is represented in one of these segments. Below is a graph[8] representing the potential sub categories for each segment.

As one can see, there are multiple subcategories under each segment. An investor can use one segment or all three when looking for investment opportunities. Typically, a fund will use all three segments and then come up with their own filtering mechanism to score its ESG components.

Shareholder resolutions and practicing other forms of shareholder engagement… The second SRI strategy is more active then just finding good social companies. This type of strategy attempts to help guide a company towards more sustainable and socially-responsible governance, through what is called a shareholder resolution. Shareholder resolution can be defined as “a formal resolution by shareholders ratifying or requesting a specified action by a corporate board.”[9] Shareholders have the right to put together a resolution pertaining to company policy and procedures, corporate governance, or issues of social or environmental concerns. It is an avenue for shareholders to influence and promote socially-responsible policies within the companies they invest.

So, is it possible?SRI investing is a wonderful concept: generate more dollars for me all while making a positive impact on society – this is the epitome of a win-win scenario. However, if we break this win-win scenario into two parts we get the following: 1) make money; and 2) make a positive impact on society. Part one is universal as everyone wants to make money (legally of course). What becomes more of a grey area is part two, the opportunity that is making you money must be making a positive societal impact. The difficulty: everyone has a different opinion on how to define “positive societal impact”. For example, earlier this year Barron’s magazine ranked the top 100 most sustainable companies domiciled in the U.S and coming in at number nine was Clorox (CLX). Yes, the company whose main product is bleach was in the top ten of the most sustainable companies[10]. Now, each company was scored on five different categories: shareholders, employees, customers, planet, and community[11] and CLX scored well in each category, but does their impact in these categories outweigh the use of bleach and its potential negative effects? Furthermore, one large ask from investors is to exclude companies which produce goods such as tobacco, alcohol, or distribute and/or manufacture firearms. This makes sense as these products can produce harm to the consumer and potentially to the public (this effect is called a negative externality[12]). Meaning, companies who produce this type of product would not be allowed in a portfolio strictly due to the product they produce, even if they are providing positive impact in other areas. As an example of a company producing such products who provide positive impacts elsewhere, Anheuser-Busch InBev NV (BUD) recently announced they will be labeling their product with a picture of a battery and the phrase “100%” to let their consumers to know the beer they are drinking was produced 100% by renewable energy[13]. In addition, over the last 30 years BUD has donated 79 million cans or 7.3 million gallons of water to victims affected by natural disasters[14]. Should we eliminate BUD just because they produce a product which people elect to drink? Furthermore, pundits have begun to express that companies with high ESG scores perform better than those who don’t. One could make the argument, that companies who are polluting, have poor employee relations, and act negatively will be hit with fines, penalties, etc. that will thereby affect their overall performance. Now, is this due to having ESG at the top of mind or is this just good business management?

The world as we know it is a complex system of things. So much so, that the sole focus of some of the smartest brains around the globe is to discover and/or describe the world in a way that can be quantified and then measured. The investment management industry is ripe for these brains as the amount of data and subjectivity is vast. SRI is a perfect example of practitioners attempting to quantify and describe a complex idea for the masses. The issue, as seen above, is SRI has become a way to generalize “positive societal impact”, which in our opinion should be individualized.

These examples are not meant to sway someone’s opinion one way or another, it is to evoke a thoughtful discussion on how to define what “positive societal impact” means and the difficulty in trying to satisfy everyone’s individualistic needs. SRI investing is a true win-win scenario and the goal of this blog was not to argue its merits. The goal is to shed light on just another investing “strategy” that seems to have lost its way in the competitive sales environment in which LBW resides.

Sincerely,

LBW

[1] We like to call it a framework, rather than a strategy. In addition, we don’t like to fit into boxes, so we tell people who meet with us that we are not value investors, we are just investors. We want to find the best return for the least amount of risk.

At the end of the first quarter (“Q1”) of every year, it begins to feel like spring (well sometimes not in WI), bringing great memories. One of my (Tim’s) favorites: the anticipation of knowing that the Salt Lake City Firefighters’ annual Lagoon day was around the corner. It was almost time to go ride the best roller coaster in UT, the Colossus[1]. I would constantly think about getting in the cart and going up the first hill, hearing click, click, click, until finally it was no more. And then boom – flying down the hill, zipping around corners, going around, not just one, but two full loops! It was a kid’s dream. Now, I may not be able to go ride the Colossus this year, but the markets in Q1 stepped in and took its place. For example, from the beginning of Q1 to its peak, the S&P 500 gained roughly 7.45%[2] (the hill). And from its peak to trough[3], it dropped -10.16%[4] (the drop), which, by definition, is a correction[5]. By the end of the quarter, the S&P 500 gained back roughly 8.93%[6] (the loops) of what it had lost and ended the quarter down -1.22%[7] (the finish).

So far, the volatility of the markets has moved as fast and as quick as my beloved roller coaster, a far cry from what we witnessed in 2017. Its twists and turns were so intense that rumblings began to surface that we may be entering the next recession. As we all know, markets move as new information is brought to light, moving up with perceived good news and down with perceived bad. And Q1 didn’t disappoint in the news department.

The momentum from Q4 2017 continued into Q1 riding high off the news of the newly cemented tax reform – “Tax Cuts and Jobs Act of 2017”. The markets continued to rally as pundits felt the tax reform would increase the bottom line of most American companies. For example, Berkshire Hathaway released its 2017 year-end results announcing its company’s net worth increased by $65.3 billion[8]. CEO Warren Buffet had this to say to his shareholders: “The $65 billion gain is nonetheless real – rest assured of that. But only $36 billion came from Berkshire’s operations. The remaining $29 billion was delivered to us in December when Congress rewrote the U.S. Tax Code.”[9] Combine tax reform with a strong beginning of the Q1 earnings season and you began finding yourself climbing a big hill, just like the Colossus.

Friday, February 2nd, 2018 was the day when the clicking noise stopped and we began our descent. The odd part – the news that day was positive. The Bureau of Labor Statistics released January’s employment and wage growth, and unemployment figures – all three exceeded expectations. In fact, average hourly earnings rose by 0.3%, increasing the yearly average to 2.9%, which was the highest level since June 2009[10]. Unemployment stayed steady at 4.1% and 200,000 jobs – 20,000 more than analysts expected – were created in the month of January. The problem – sometimes with economics, good news is bad news. The markets looked at this and began to evaluate how these positive numbers could impact inflation, interest rates, and the growth of the economy. The following Monday, eyes were fixated on newly appointed Fed Chair Jerome Powell and the path moving forward for the Federal Reserve. Questions like “How fast will the Fed increase interest rates?” or “Are we at the peak of this historical bull market?” surfaced and the markets began to fall further. That day[11] the S&P 500 dropped -4.10%, totaling a two day drop of -6.22%. On Thursday, February 8th, 2018 we hit the bottom of the hill. The S&P 500 dropped by -3.75%, once again the thought of the economy improving meant inflation was going to increase and the country would have to begin weaning itself off artificially low interest rates and intense monetary measures.

As we started accelerating to the loops and the dust settled, the markets gained as we technically corrected and companies’ earnings were strong. The markets were thrown back into a frenzy as the Trump administration and China trade talks began to intensify. Unlike the positive economic data, as the discussion began to go further into the depths, the markets began to waver in their optimism. If the proposed tariffs were to go through, pundits felt it would slow down growth both domestically and globally. Once again, fresh news threw the markets back and forth as the future of trade and economic growth became increasingly uncertain.

As one can see, the markets truly did match my childhood roller coaster – the only difference: actual roller coasters are more fun. The gyrations in the markets were intense and we are beginning to glide closer to the peak of economic expansion and most people recognize this. It comes down to the same old question “Are we in the 7th or 9th inning?”, but the reality is no one knows. The only thing truly known is that market cycles are healthy and expected. As inflation increases and the Fed begins to pump the breaks on monetary easing, our economy will begin to tighten. If the economy begins to tighten, it could affect the overall growth and potentially throw us into what is considered a recession[12]. Add in the current geopolitical risks, and the slowdown in economic growth could accelerate. This thought process is not our way of predicting the next downturn, but it does beg the question on where returns will head over the next ten years. The last decade has produced exceptional returns and moving forward we feel similar returns will be harder to achieve. Volatility in the markets can be your friend. As we state in almost every commentary, we are aware of macro factors, we just don’t allow them to dictate how we invest. We attempt to mitigate this risk by performing thorough research, having a long-term investment horizon, and understanding what we own and pairing with others who do the same. We will continue to watch out for opportunities, and when they present themselves, we will be ready to pounce.

Nathaniel's Beautiful Mind

​Mutual Fund SpotlightThe GoodHaven Fund started operations in 2011. Its co-founders, Larry Pitkowsky and Keith Trauner, met one another at Fairholme Capital Management (FCM) when they first started working there in the same year (1999). They both left FCM in 2008, and after their applicable non-competes ended, they launched GoodHaven. These two are not only incredibly open with their line of thinking regarding their portfolio holdings, but also with exploring their mistakes. Their portfolio holdings have been in sectors such as oil & gas exploration & production, metals & mining, diversified holding, tech, and financials. I’m comfortable with companies in some of these areas, but certainly not all. We know that Larry and Keith have in-depth knowledge of their holdings and are not only comfortable with enormous bouts of volatility but love to take advantage of volatility when it occurs. These are exactly the kind of managers that we feel comfortable placing our client’s money with.

My Thoughts on CommerceHub being Bought OutFor this quarter’s writeup, I wanted to give you a peak under the hood of what I think about when making a portfolio management decision. To do this, I’m going to discuss the buyout of CommerceHub[13] (CHUBA/K), why I’m not pleased with the proposed transaction, and why I ultimately decided to sell out of the position.

Before we jump to our opinions of the transaction, a little background on CommerceHub and the transaction. On March 6, 2018, CommerceHub announced they were being taken private by two private equity firms, GTCR and Sycamore Partners for $22.75 per share in cash. The expected closing date of the transaction will be in 2018 Q3. CommerceHub’s price immediately rose to the $22.30-$22.50 mark across all its respective share classes. A little history: CommerceHub was spun off from Liberty Ventures (LVNTA) on July 22, 2016. For our clients who have been with us for a while, you may remember us writing about the former tracker stock[14] LVNTA’s exchangeable debentures and it being controlled by one of our favorite capital allocators, John Malone. Because of the spinoff, Malone maintained voting control of CommerceHub.

CommerceHub is a SaaS company acting as a middleman and drop-shipper for Retailers like Walmart or Target to connect to Brands/Suppliers like Nike or Samsonite, and Delivery services like UPS or FedEx, while offering Marketing and Social Media services to all three of these categories, all via one connection. If a big retailer like Walmart decides to come on board, they will typically require their suppliers to come onto the platform as well. These suppliers will then connect to CommerceHub, and Walmart will essentially have virtual inventory. That is, Walmart will be able to observe their suppliers’ inventories in real-time, which allows Walmart to not only be more efficient with real-time data, but to also lower their working capital requirements by not having to have as much inventory on hand. With Walmart now able to see this virtual inventory, Walmart can now do something called drop-shipping. Drop-shipping is when a Walmart customer orders a pair of Nike shoes via Walmart.com, and the order is shipped directly from Nike’s warehouse, but is then white-labeled to appear as if it came from Walmart.com. CommerceHub typically charges a subscriber fee to maintain a connection to their platform, and then a usage fee for all inventory that flows through their platform. As more retailers come onto CommerceHub’s platform and more suppliers follow the retailers, CommerceHub’s network effect will grow. As their network effect grows, their moat grows increasingly stronger.

As one can imagine due to CommerceHub’s moat, the company’s economics were quite enticing. Here’s what I liked about CommerceHub:

It didn’t matter if Revenue growth wasn’t increasing at some crazy exponential growth rate because its Free Cash Flow (FCF) was growing at a 25+% IRR[15]

2017’s Return on Invested Capital was astounding at 75+%, and had grown at a 30+% IRR[16]

CommerceHub had net debt of ~$34.9M starting in 2016 Q2, and by 2017 Q4 had paid it down and had a net cash balance of ~$19.8M. That’s a $54.7M swing in 1.5 years.

Most investors would be rejoicing – we’re not. Here’s what I don’t like about the transaction:

Not a great price for shareholders: I believe the proposed offering price undervalues CommerceHub by approximately 10-15% if I use 2017’s ending FCF of $35.5M

Opportunity Cost: I estimated that CommerceHub’s FCF could grow ~20+% for the next 10 years. If bought at the right price, of which there were many opportunities to do so throughout its short tenure as a publicly-traded company, a shareholder would likely reap high returns on their investment. Now, if CommerceHub is taken private, our clients will miss out on owning such a great company. Upon the transaction’s completion, I now must find a similar if not better idea selling at a good price to compensate for CommerceHub being taken off the table. I can tell you that especially right now, such opportunities are very hard to find.

Now we get to the portfolio management reasoning behind the sale of our client’s shares. The aforementioned notwithstanding, I had a decision to make regarding whether I sell now or hold till the transaction’s proposed closing date (2018 Q3). As I saw it, once the transaction was announced, it was in our clients’ best interests to sell their CHUBA and/or CHUBK shares. Below is my thought process:

The transaction doesn’t go through: for whatever reason, the deal falls through. The share price falls, perhaps to the price range I’m willing to buy at, and I buy back shares for our clients. In the off chance I haven’t sold the shares yet, this is a possible means to make amends if the price goes into my buyable range. In addition, our clients maintain ownership in a compounder.

The transaction goes through at the proposed price of $22.75 per share: as the stock was trading in the 22.30-22.50 range, it didn’t make sense to hold on for another ~6 months till the transaction closed, simply to get an extra 1-2% return. The proceeds of the sale could be utilized as dry powder when an opportunity came knocking.[17]

Another suitor comes in and offers a higher price: based on my calculations, CommerceHub’s buyout price was undervalued by ~10-15%. Hence, we could miss out on a potential 10-18% increase from the $22.75 offer price. However, this was not a hostile bid as the company actively put itself out there as a potential buyout target. This scenario’s odds were low in my opinion.

I also took into consideration short-term versus long-term capital gains. As many of our clients know, we like to say that “we’re tax-aware, not tax-efficient”. I went through all our clients’ accounts that held CHUBA and CHUBK to see if I could get our clients’ gains into long-term capital gains’ rates territory. Here are the statistics:

All CHUBA shares had been purchased before this date, and therefore were already in long-term capital gains’ rate territory. 42.2% of our clients’ CommerceHub shares were CHUBK shares and had been purchased after July 1, 2017, and 26.9% after October 1, 2017.

Of that 42%, the average cost basis per share for CHUBK was $18.15.

CHUBK’s closing price the day before the announcement (March 5, 2018) was $17.47.

Assume a conservative sale price of $22.30, and earliest estimated closing date of July 1, 2018 (first day of 2018 Q3).

Conservatively assume that all clients are in the highest marginal tax bracket of 37% for short-term capital gains’ rate and subject to a 20% long-term capital gains’ rate only (for purposes of this example, let’s assume the 3.8% Medicare surtax does not apply).

Here’s what I found: Even if I waited till the transaction closed sometime in 2018 Q3, 26.9% would be almost guaranteed to have short-term capital gains and 15.3% would possibly be subject. Assuming that 15.3% could be subject to long-term capital gains, let’s compare the difference between selling in early March versus waiting till the transaction closed. If I sold post-transaction announcement in early March at a conservative sale price of $22.30 and had an average cost basis per share of $18.15, the gross cumulative return would be 22.9% ([$22.30-18.15]/$18.15) and short-term capital gains would subtract 8.5% (22.9%*37%), leaving a net return of 14.4% (22.9%-8.5%). If I were to wait till closing, the gross cumulative return would be 25.3% ([$22.75-18.15]/$18.15) and long-term capital gains would subtract 5.1% (25.3%*20%), leaving a net return of 20.3% (25.3%-5.1%). I then measured the difference between the net return had I sold in early March of 14.4% versus transaction close of 20.3% to be 5.9%. I compared this -5.9% difference in return, applicable only to the 15.3% of shares that would possibly be subject to long-term capital gains, to what would happen if the transaction terminated. I assumed that the price would fall from $22.30 to the $17.47 price it closed at before the announcement, which would equal a gross return of -21.7% ([$17.47-22.30]/$22.30). I compared the potential -5.9% return difference versus the possible loss of -21.7% and decided it was well worth the risk to sell now versus waiting till the transaction’s close.

To sum up, CommerceHub was a good investment and we were disappointed to see it come off the table; however, the return generated in a short time frame was nice. My goal with this quarter’s commentary was to bring our clients into the trenches of both investment management and portfolio management. At times, the two can conflict and I do my best to ensure I make the best possible decisions on behalf of our clients, and CommerceHub happened to be a prime candidate at showcasing the difficult decisions I sometimes have to make. I believed that the transaction is likely to go through, and decided it was in our clients’ best interests to sell all their shares after the announcement even after considering the impact of short-term capital gains. Despite my reservations about the offer price and having to find another actionable idea as good as CommerceHub, it was ultimately the best decision for our clients. I hope you enjoyed this dive into “Nathaniel’s Beautiful Mind”.

In our blog, “Making the Bet - Part 1: The Game”, we made the point that concentration is often viewed in a vacuum and instead needs to be viewed holistically. Doing so can uncover concentration and previously-unknown risks. However, concentration from a finite level – such as a portfolio level – is just as concerning. If possible, one must be aware of their concentration on a macro level (“The Game”) and a micro level (“The Hand”).

The Hand and its concentration is often the one people think of most. Advisors are typically discussing diversification inside their clients’ portfolio(s) and that spreading your eggs amongst baskets reduces portfolio risk. Furthermore, it is easy for an investor to see. The information is typically gathered in one place, and analytical software can produce beautiful graphics flawlessly showing the concentration behind The Hand. At LBW, we don’t disagree with diversification and recognize its risk-reducing nature. However, we feel there is a misconception behind how concentrated The Hand should be and why concentration could reduce risk and increase returns.

Risk – let’s start there. Risk can be defined as “the chance that an investment (such as a stock or commodity) will lose value”[1]. This definition is cut and dry – create a portfolio that won’t lose money – if it was that easy we wouldn’t be writing this blog. The problem is, investors sometimes don’t agree on how to measurer risk. One widely-used metric is called beta; below is a brief description:

“Beta measures the responsiveness of a stock's price to changes in the overall stock market. On comparison of the benchmark index for e.g. NSE Nifty to a particular stock [sic] returns, a pattern develops that shows the stock's openness to the market risk. This helps the investor to decide whether he wants to go for the riskier stock that is highly correlated with the market (beta above 1), or with a less volatile one (beta below 1).

For example, if a stock's beta value is 1.3, it means, theoretically this stock is 30% more volatile than the market. Beta calculation is done by regression analysis which shows [a] security's response with that of the market.

By multiplying the beta value of a stock with the expected movement of an index, the expected change in the value of the stock can be determined. For example, if beta is 1.3 and the market is expected to move up by 10%, then the stock should move up by 13% (1.3 x 10).

Beta is the key factor used in the Capital Asset Price Model (CAPM) which is a model that measures the return of a stock. The volatility of the stock and systematic risk can be judged by calculating beta. A positive beta value indicates that stocks generally move in the same direction with that of the market and the vice versa.”[2]

Beta is based on the price volatility of said stock and the benchmark it is compared to. Said differently, if the stock price moves more than the benchmark it would be deemed riskier. And if its price were to move less, it’s less risky. If this were to be true, then one would need to assume the stock’s price is equal to its intrinsic value (what that company is worth). Furthermore, sometimes the mechanics of the market is misunderstood. Take for example, the New York Stock Exchange (“NYSE”). It is a place to buy and sell shares of companies and is considered a secondary market. Meaning, individuals buy and sell to each other at prices they feel each company is worth. It is up to the individual to assess the value of the company. Meaning, beta assumes the public is valuing each security at its appropriate price. Herein lies the issue, people aren’t always right, and sometimes they will sell shares at values that are too high, low, or exactly right. If you are in LBW’s camp and don’t feel people adequately value companies all the time or have a long-term investing horizon, then price movements don’t equate to risk, and companies’ actual health (i.e. their debt loads, brands, competitive advantages, etc.) do.

Risk is only one part to the investment equation; the other is return potential. Just because we may understand the risk to an investment doesn’t always mean the return on the investment will be great. To understand the return potential, homework must be done on the investment’s prospects. Combine the risk and return, and now The Hand can begin to be played. For example, let’s say Linda is playing poker and her Hand is a Full House. Should she bet big, fold, or check (let’s not assume she is trying to play games with the pot, which is very real in the game of poker)? The probability of Linda even getting this type of Hand is 0.1441%[3], meaning the likeliness of her winning is extremely high since there are only three hands that could beat her. So, if Linda is an experienced player, she should bet BIG! Understanding your investment is obviously a large part to reducing your risks and increasing your returns. Therefore, we tell many of our clients with closely-held businesses that reinvesting in their companies instead of the public markets could potentially derive higher returns, and one main reason is they understand the mechanics behind their respective money-generating machines.

Now we can begin to see why there is a misconception behind diversification. If one can truly understand their investment, they can begin to concentrate on their best ideas. For example, telling Bill Gates to diversify away from Microsoft in the beginning years, seems like a laughable joke – he’s made billions being highly concentrated in one company. However, Mr. Gates knew what he was tying his horse to, because he built the carriage. The point is, the level of concentration on one asset shouldn’t be determined by a random percentage, but by its risk/return profile based on the fundamental knowledge you have about said asset. And if you don’t understand the investment, placing large bets isn’t prudent. For example, cryptocurrency, such as Bitcoin, was the rage of 2017. For the public, investing a large amount of assets in Bitcoin probably wasn’t prudent. However, investing 0.25% of their portfolio would have been a prudent move – it would have limited the risk with the potential for exponential upside. In addition, the majority of your assets shouldn’t be invested in a business because your best friend from kindergarten told you it was going to be the next best thing; maybe 1%[4] of your investable assets would do just fine.

We are not advocating that concentration is the way to go; we are asking people to rethink how they should approach diversification. Diversification has its place as it does reduce risk to a point, especially if you are unable to put in the time to properly research potential investments, but if you understand your investments’ risk/return profile and have a long-term investment horizon, concentrating on the best ideas can be fruitful.

​The word concentration is frequently used in the financial world. Phrases like “you need to be more diversified to avoid concentration” or “you are over-concentrated in equities” are often thrown around by financial professionals, and for good reason, as concentration is a real risk. The issue, however, is these phrases likely pertain to concentration in an asset class, individual company, or some other related stock market investment. Such assessments are made with isolated information, instead of being examined from a holistic view point.

Generally, concentration can be defined as “a close gathering of people or things”. Relating this to finance is easy. Take Bob, who has a $1,000,000 (the number of dollars is our “thing”) investment portfolio and $500,000 of that portfolio is invested in XYZ stock (the company Bob works for), and the rest is invested in mutual funds where his next largest position makes up $20,000 of the portfolio. Meaning 50% of Bob’s investment portfolio dollars (again our “things”) are gathered in one place. Based on the definition and information provided, anyone could conclude that Bob is highly concentrated in one investment, his company’s stock. However, all we have done is examined the total percentage of dollars that makes up one position in an investment portfolio. We have isolated our information to only one data set, a $1,000,000, instead of asking Bob about his entire financial picture.

If we approached this concentration question with a new lens and asked Bob what other financial assets he has, it would reveal the following:​

In 2018, will receive an additional $500,000 in XYZ stock that has a five-year vesting period

This new information begins to alter our thoughts on concentration. For example, in Chart 1[2] the percentage of XYZ stock[3] if compared to Bob’s total investable assets[4] is 28%, significantly lower than the 50% we derived from the limited information above and only 7% higher than his real estate holdings.

​In addition, we need to take into consideration that 50% of the 28% of XYZ stock is dependent on Bob not being terminated or leaving XYZ company in the next five years. Let’s look at what would happen if Bob did leave within five years.

​If Bob were to leave for any reason within that time frame, his concertation in XYZ stock would be 16% of his total investable assets. And his real estate holdings would be 25%! Furthermore, if we examine both Chart 2[5] and 3[6], we can see that much of Bob’s income is being derived from XYZ company, which is typical, but he is solely dependent on XYZ company for life insurance.

One can now conclude: yes, even if Bob were to leave for any reason in the next five years, he is still concentrated in XYZ stock. However, we have uncovered two other forms of concentration:

Bob’s total concertation within XYZ company: 28% of Bob’s total investable assets, 98% of his income, and 100% of his life insurance is tied to the health of XYZ company[7].

Bob’s concentration in real estate: 21% of his current total investable assets are concentrated in real estate and if he were to leave within five years, it would jump to 25%[8].

As we know, Bob’s example is fictitious, but it is a good representation of most Americans today. Many of us, regardless of income, are tied to our employers. And as we move up the ranks and begin to receive raises and more complex compensation packages, this concentration and dependency can worsen. As our income rises so too does our cost of living; this phenomenon is called lifestyle inflation. If we succumb to this type of behavior, we may never be able to get away from the concentration of our employers. Furthermore, real estate is always a hot topic when speaking with individuals; it’s a tangible asset people can touch, feel, and enjoy (a far cry from owning a company’s stock) leading them to want more of it. However, just like Bob, it is often missed that the majority of households already have a large concentration in real estate through their own primary residence. If one were to continue to spend their money on real estate property, they may not realize the amount of money they have tied up in an asset that can be highly illiquid.

Taking a holistic approach to concentration can uncover risks and opportunities that may have been hidden without further dissection. If approached this way, one can begin to make educated financial decisions that will positively affect their entire financial picture. It allows us to see where our true exposure is and if pressed with the question of, “Can I leave my job?” we know what is at stake and the holistic compensation package we would need to make the jump, instead of solely focusing on the salary we may receive. This awareness is crucial, as it puts an individual or household back in the driver’s seat to a healthy financial well-being.

CLIFF HANGER – as the title sweuggests, this was part one of a two-part series. Next month we shift gears and discuss concentration as it pertains to investments and why concentration and less diversification within investable assets is not necessarily a bad thing; if you understand what your investing in…TO BE CONTINUED.

[7] To keep this example short and sweet, other items that may tie Bob to XYZ company would be health insurance, disability insurance, 401(k) match, etc. In addition, we need to keep in mind that if Bob were to leave XYZ company his new job may provide similar benefits. If they don’t or their benefits are significantly worse, Bob may have a tough time finding new employment.

​Introduction This month’s blog is going to be slightly different than usual; rather than having Tim, Nathaniel or Dan discuss a financial topic, I’ll be writing about my perspective of the financial services industry. But before we get into that, a brief introduction is in order.

My name is Darin Krumenauer; I’m a student at the University of Northern Colorado (UNC) and will be graduating with a degree in finance later this spring. Prior to graduation, UNC requires business students to have completed an internship in their respective fields of study, and thus begins my connection with LBW.

I grew up in Sauk City, Wisconsin, and return each winter to visit family for the holidays. As luck would have it, one of those family members happened to be good friends with Dan at LBW. Introductions were made, and shortly thereafter the team at LBW agreed to bring me on as an intern during my holiday break.

LBW gave me my first real experience in the world of finance, and that’s exactly why they asked me to write this blog. They saw an opportunity to provide readers with an unfiltered discussion about financial services because, like most people, I didn’t know anything about it until recently.

Before LBWPrior to working with LBW I knew little about what jobs were available to me in the industry, aside from banking and corporate finance. I was interested in financial services, but I didn’t know where to start. And when I asked, it seemed like I couldn’t get a straight answer from anyone. Internship fairs and recruiting events were dominated by big-name finance companies offering ‘Financial Advisor’ positions. These turned out to be nothing more than glorified sales positions, paying commission for selling insurance and investment packages to family and friends – not my idea of a good time. My goal with a career in finance was to help people of any income level achieve a better standard of living, so that they wouldn’t have to worry about finances. I started to worry that a job like that didn’t exist.

Learning CurveWhen LBW agreed to the internship I realized I would finally be exposed to the inner workings of financial services, and whether I loved or hated it, I would at least know where to move forward. As I began working with the team, I immediately realized that they were the missing piece of the puzzle. The level of care and attention to detail that LBW was giving to clients was exactly what I wanted for a future career. There was one thing that I couldn’t figure out: why hadn’t I heard about this type of firm before? Thinking on this, I’ve concluded that there is a huge issue with financial services.

Some big firms in the industry are thriving on obscurity, using unnecessarily complex verbiage and pushy sales tactics to rampup commission sales. I know this because I’ve experienced it personally. If a good student with a thorough comprehension of finance has a difficult time understanding what he’s really investing in, why would someone with no background in the subject be expected to? It’s simple – they aren’t meant to. If these clients fully understood what they were being sold and could compare it to an independent firm like LBW, I’d wager that an overwhelming majority would go with the independent firm. I’m not saying that every big firm is bad, and every independent firm is good (I’ve researched dozens that aren’t). My true intent is to get people to start questioning the industry so that they can make more informed decisions about where they are putting their money.

As people begin to understand what they’re investing in, they will start to recognize firms that truly act in their best interest as well as firms that don’t. This brings the conversation back to LBW. During the internship I was exposed to every function of their business, including sitting in on client meetings (and for those of you whom I had the pleasure to meet, I sincerely thank you for allowing me to join in those conversations). The two- to three- hour introductory meeting that prospective clients receive blew me away, not because of its length or the fact that it’s free of charge, but because the primary goal is to educate those individuals so that they understand exactly what the firm is providing. It’s no wonder that LBW has seen tremendous growth since their inception; people recognize just how rare it is to find a firm as genuine as they are.

After LBWWith graduation drawing closer by the day, I’ve researched dozens of firms to try and find a suitable place to start my career. The unfortunate truth is that I have yet to find one that comes close to what I experienced with LBW. Because of this, I am even more confident that a change must take place regarding financial services. People work hard for their money and deserve to understand where they can maximize its value. My new goal: to be part of a fundamental shift in the industry, making it both stronger and healthier for everyone.

For those of you who made it this far, thank you for reading! If you have any questions or comments specifically for me, please contact LBW and they’ll pass my information along to you!

Please note: this blog is an expression of my thoughts and opinions alone, and does not necessarily represent LBW Wealth Management in any way.

When defining the 2017 market, one could use phrases such as “good”, “better than expected”, or even “great”; just look at Chart 1[1]

Across the globe, markets climbed higher. Both the S&P 500 (“S&P”) and the Dow Jones Industrial Average (“Dow”) hit record highs within the year, and international markets witnessed the growth many pundits have been calling for the past few years. Furthermore, these returns pushed the U.S. bull market into its ninth year[2]. As many of our readers know, LBW focuses on long-term investing where long-term starts at 10 years. So, let’s shift gears and examine the past 10 years of the S&P 500 TR’s returns in Chart’s 2[3] and 3[4].

Over this time frame, the S&P 500 TR has had an 8.50% annualized return and has had a cumulative return[5] of 126%[6]. To place this into perspective, depending on how 2018 goes, the 10-year annualized return for the S&P 500 TR should see a significant increase as 2008, which posted a negative -37.0% return, will roll off and will not be included in the 10-year annualized return metric, and thereby exemplifying the extended bull market we have witnessed over the past nine years. Furthermore, these metrics begin to help paint the picture of 2017 and its potential for irrational exuberance[7].​Irrational exuberance can be defined as “unsustainable investor enthusiasm that drives asset prices up to levels that aren't supported by fundamentals.”[8] For 2017, we witnessed an array of events we feel have inched us closer to an irrational exuberance mindset. For example, for years following the Great Recession many market participants sat on the sidelines worrying that the bad times were only in the early innings. Fast forward to today, the sidelined money has come back as returns have been nothing short of good. The key is not that money has reentered the market assisting the climb in asset prices (although this is a factor), but the anchoring[9] that may be occurring with the new return profile. When the Great Recession was in full effect, market participants anchored on the negative returns causing them to exit the market. In other words, market participants saw negative returns and assumed they would stay there forever. As time went on the markets climbed back, and now we have witnessed one of the longest bull markets in U.S. history. Once the annual return for 2008 is removed from the S&P 500’s TR 10-year annualized return, the new return profile will most likely cause a sense of security, and market participants may assume returns like 2017’s should be expected going forward.

Interest rates are another factor to consider when examining the tilt towards irrational exuberance. Since the beginning of 2008, the 1-year U.S. Treasury rate has declined by -47%, the 10-year by -41%, and the 30-year by -38%[10] due to Quantitative Easing and other monetary policy levers. Artificially lowering interest rates was a tool to boost the overall economy and help the U.S. climb out of the Great Recession. This seems to have helped the markets; however, it may be forcing investors to take on more risk for smaller returns. For example, let’s say an investor is looking to invest their money in a place where they could receive a modest yield of 6%. As seen below in Chart 4[11] they wouldn’t even be able to achieve their goal if they invested in the High Yield[12] bond market.

Thus, market participants are moving down the capital structure and are investing in company equity with high dividends to achieve their desired return. In short, more money is entering the stock market as market participants are willing to take on more risk to achieve higher yields.

Fiscal policy in 2017 was another sign of setting up an irrational exuberant path. The topic topped the headlines as the new administration overhauled tax legislation, with big benefits going towards corporations and moderate tax relief for individuals. The thought was to tax corporations less in order to allow them to grow, create new jobs and provide working Americans with more discretionary funds in hopes that they would spend more money on discretionary purchases. This will most likely provide a short-term boost to the economy, and has already pushed asset prices higher. In addition, the new administration has been upfront about its pro-business agenda, and are looking to deregulate industries such as the financial sector. This deregulation could allow for banks to revert to their loose-lending ways by incentivizing them to veer towards short-term profit endeavors. Furthermore, unemployment is at one of its lowest levels in over 10 years and companies are having a hard time finding talent. The job supply could be lulling individuals into a false sense of security, with them thinking that unemployment is a thing of the past.

The cryptocurrency craze of 2017 is another factor leading us to think irrational exuberance is starting to show its face. Bitcoin’s price, one of the mainstream cryptocurrencies, increased 1,204%[13], meaning you could have turned $100 into $1,304 in one year. However, this craze was based on speculation as Bitcoin is only worth what someone is willing to pay for it (the “greater fool” theory). It does not produce cash, nor does it have an intrinsic value (if you want to know more about LBW’s thoughts on cryptocurrency, read our blog post “Cryptic Currency”). Bitcoin’s decentralization, capped unit amount, and blockchain technology are all reasons to think that our perception of payment processing and fiat currency may need to change. However, it is too early to tell and is still highly speculative. Having individual investors join in such a frenzy may indicate people might be looking for higher returns, have more disposable cash to invest, or are becoming more comfortable with the markets in general. These are some of the very factors that indicate irrational exuberance.​If you take each factor: interest rates potentially staying at artificially low levels, short-term stimulus from tax legislation, deregulation, low unemployment, positive market participant sentiment, and then throw on top the potential increase in the S&P 500 TR 10-year annualized return as 2008’s returns fall off, we may begin to see market participants drive further into irrational exuberance’s depths. This hype could drive our nine-year bull market into a 10-year streak further inflating asset prices to new levels. The issue: our perception hinges on future market returns based on past events and results. This simple point could lead us into new market heights; however, that does not mean the price is equal to the asset’s value. Only time will tell how far we are into the cycle of irrational exuberance.​Nathaniel's Beautiful Mind

Mutual Fund SpotlightArtisan Partners was started in 1994 by Andrew & Carlene Ziegler. On March 7, 2013, Artisan Partners began publicly trading on the New York Stock Exchange. They saw an opportunity to hire great talent to take advantage of the trend toward open architecture investing platforms. Artisan is structured with small, autonomous teams that are each focused on their respective investment spheres. We have especially like the Global Value team for their International Value & Global Value funds and their portfolio managers David Samra & Dan O'Keefe.

David Samra & Dan O'Keefe have been working together since 1997 when they met one another at Harris Associates, the advisor to the Oakmark Funds. After they moved to Artisan, they both received Morningstar’s 2008 & 2013 International Stock Fund Manager of the Year award. They and their team are generalists, versus focusing on industries, and look for cheap companies with great business models and solid balance sheets that are run by good management. We like them because of their critical thinking acumen, defined processes, and unwillingness to veer from their knitting, so to speak.

Liberty Ventures: Opportunity to Invest in Two Compounders at a DiscountAs mentioned in our updates, I presented one of my best ideas for the MOI Global membership community. MOI was kind enough to allow us to distribute my presentation to our clientele. Unfortunately, we have not yet received the link, and will not be able to share within our commentary as we had hoped. However, we should be receiving it soon and instead of delaying your reports any further, we have decided to send a follow up with the link attached. Until then, below is a preamble to my presentation.

Liberty Ventures trades as a tracker of the company Liberty Interactive and is scheduled to be split off as GCI Liberty in 2018. It has in the past been an investment incubator for the companies that owner-operators John Malone and Greg Maffei have invested in over the past decades. They have slowly streamlined the tracker, splitting and spinning off companies as they near fruition. Nathaniel believes that Liberty Ventures offers an opportunity to invest in two compounding companies, Charter Communications and General Communications, at a discount, with a long runway for investing large amounts of capital at high incremental returns.”[14]

[7] The term is thought to be coined by former Fed Chairman Alan Greenspan during his speech titled “The Challenge of Central Banking in a Democratic Society” at the Annual Dinner and Francis Boyer Lecture of The American Enterprise Institute for Public Policy Research, Washington, D.C. December 5, 1996.

At some point in life you’ve probably thought, “I wish I could get paid without having to go to work.” Luckily for you, that’s exactly what an IRA is for: saving enough money now so that you can pay yourself not to work (commonly known as retirement). To understand how this is done, let’s start with the basics:

What is an IRA?

IRA stands for “Individual Retirement Arrangement”.[1] Simply put, they are accounts with certain tax benefits, which differ depending on the type of account, for individuals saving for retirement. Although there are several different kinds, we’ll be focusing on the differences between a traditional IRA and a Roth IRA.

Traditional IRA Structure:

Any contributions that are made to the account are partially or fully tax-deductible, depending on your situation:

1. If you OR your spouse has a retirement plan through work, your deduction might be limited. Follow this link[2] for more details.2. If you don’t have a retirement plan at work or your income exceeds certain levels, any contributions you make are fully deductible. However, the maximum annual contribution, for 2017 and 2018, to both traditional and Roth IRAs is $5,500 for investors under age 50, and $6,500 for investors over that mark.[3]

There are also rules for taking distributions from the account:

1. Any withdrawals from the account are subject to your income tax rate at that time;2. In general, withdrawals taken before age 59 ½ are subject to your income tax rate as well as an additional 10% penalty. Click here[4] to see the exceptions;3. After age 59 ½, the investor is free to take any size distribution without penalty

Roth IRA Structure:

Unlike a traditional IRA, any contributions made to the Roth account are after-tax and cannot be deducted. The implication here is your Roth contributions are taxed at your current tax rate. Because of this, when distributions are taken at retirement, they are not taxed – including any possible capital gains.

Roth IRAs also have distribution rules, but they aren’t as restrictive as traditional IRA rules; www.rothira.com sums them up best:

1. “If you are 59½ or over, you may withdraw as much as you want, as long as your Roth IRA has been open for at least 5 years;2. If you are under 59½, you may withdraw the exact amount of your Roth IRA contributions with no penalties;3. There are special exemptions for first-time home purchase and college expenses.”[5]

To see the full list of exemptions, click here[6] and scroll to the section titled ‘Non-qualified distributions’

Which IRA is best?

As always, the best option is dependent on the individual/household’s situation. That being said, the benefits of both IRAs are largely differentiated by taxes, so we’ve mapped out some scenarios to help get you pointed in the right direction:

A Traditional IRA might be more beneficial if:

1. You’re in a high tax bracket now, but expect to be in a lower tax bracket during retirement.

Why?: When distributions are withdrawn at retirement, they’ll be taxed at your tax rate at that time.

2. IRA contributions you make today qualify as tax deductions.

Why?: The value of the tax deductions may outweigh the tax expense incurred when taking distributions.

​​A Roth IRA might be more beneficial if:​1. You’re in a lower tax bracket now, but expect to be in a higher tax bracket during retirement.

Why?: When distributions are withdrawn they aren’t taxed, which saves you from paying the difference between your high tax rate at retirement and your lower tax rate now.

2. You’re able to contribute to the account without putting a strain on your finances.

Why?: You don’t pay taxes on the distributions when you retire, so any earnings that the account has made go straight into your pocket.

3. You need to take distributions from the account to pay for a college degree.

Why?: You can withdraw from the Roth account to cover higher education expenses for yourself or eligible family members.

At this point we’ve covered the structures of both IRAs, as well as some scenarios that benefit each. The last few examples provided below should help tie everything together, giving you a visual representation of how the traditional IRA and Roth IRA differ from a numbers’ standpoint.

For each of the three examples below, the following assumptions were made:1. The investor is a 35 year-old male who plans to retire at age 65,2. He does not have a retirement plan through work,3. He contributes $5,500 annually to his IRA (the maximum amount allowed if you are younger than 50),4. He makes $100,000/year, placing him in the 24% tax bracket (new for 2018),5. His IRA earns a reasonable 7% annual rate of return, and6. He plans to take distributions from the account from age 65 to age 90.

​In addition to the criteria above, this example assumes that the investor will drop down to the 22% tax bracket during retirement. The chart on the left shows that the Roth IRA is the best value for our hypothetical investor, allowing annual distributions of $47,473 from age 65 to age 90. The total value of the Roth account, shown on the right, is just over $1.2 million.

We mentioned earlier that if you have a lower tax rate at retirement than you do now, a traditional IRA could be more beneficial. Even though that can be true, the minor change in dropping from 24% to 22% for this scenario isn’t enough to put it ahead of the Roth account. However, the value of the traditional IRA is the highest amongst the three scenarios, which illustrates the possible advantage it can have given different circumstances.

​This scenario assumes that the investor’s tax rate remains at 24% when they reach retirement. The value of the traditional IRA is slightly lower when compared to Scenario 1, reiterating the benefit it can have by paying a lower tax rate in retirement. As you might have noticed, the value of the Roth IRA hasn’t changed because the investor’s current tax rate remains the same for each example.

​This final scenario assumes that the investor’s tax rate increases to 32% at retirement, producing the most significant impact on the traditional IRA thus far.​Final ThoughtsUnderstanding the differences between these IRAs is just one of many steps in planning for retirement, and we’ve only scratched the surface. The large role taxes play on the benefits of each IRA makes it extremely important to consider how short and long-term changes could impact their value. The same is true of your income stream; if it increases or decreases, how will it influence the value of your IRA? These questions and evaluations are just the tip of the iceberg, but you need not get discouraged! The quality folks at LBW are here to help you make informed decisions that are entirely your own, because the better you understand what your options are, the more comfortable you’ll be with the investment.

Thank you for taking the time to read our blog! If you have any questions or comments regarding the information we’ve covered please don’t hesitate to give us a call, your feedback is always appreciated and welcomed.

]]>Thu, 30 Nov 2017 18:29:53 GMThttp://lbw-wealth.weebly.com/blog/opportunity-costthere-is-no-such-thing-as-a-free-lunchThe first day of my (Tim) Introductory Microeconomics class our teacher provided us with a few key tenants surrounding microeconomics; 1) assumptions must and will be made (I still don’t agree with this principle and feel it can distort the real world – maybe it will be our next blog post), and 2) there is no such thing as a free lunch. The second point baffled me at first. I had heard of opportunity cost, but I had never truly sat down and thought of its real-life application. Our teacher began peppering us, attempting to see if we could break this fundamental rule. It is a difficult and an almost impossible task. Anything you do has another side of the story; as humans, we are constantly battling a zero-sum game[1]. Opportunity cost is real and is a core tenant not only in economics, but in your financial plan as well.

​Opportunity cost can be defined as:

“…a benefit that a person could have received, but gave up, to take another course of action. Stated differently, an opportunity cost represents an alternative given up when a decision is made. This cost is, therefore, most relevant for two mutually exclusive events. In investing, it is the difference in return between a chosen investment and one that is necessarily passed up.”[2]

For example[3], let’s assume Bob, at his current job, makes $50,000 per year and would like to make a job change because he is unhappy. However, Bob can only find jobs where he will make $35,000 per year with the potential for raises in the future, but feels he will be happier at the other jobs. Bob is now surrounded by opportunity costs. From a salary point-of-view, Bob would be hit with a $15,000 opportunity cost per year. If we assume he does not receive a raise for five years, that would be a $75,000 opportunity cost over five years! Stated differently, is Bob’s happiness worth $15,000 year? Now, I understand this seems harsh and Bob’s happiness, to quote Mastercard, is “Priceless”. However, as harsh as it may seem, it’s reality. For example, what could have Bob done with $75,000 over five years? Had an earlier retirement? Helped support his children through their college years? Gone on an awesome vacation once a year? You can see my point – opportunity cost is real and makes financial decisions extremely difficult.

Inside our Bob example, there are few things going on if you were to look at it through an economic lens. We are attempting to find Bob’s utility for more money. Utility is described as:

“…a measure of preferences over some set of goods (including services: something that satisfies human wants); it represents satisfaction experienced by the consumer of a good.”[4]

Essentially we are trying to gauge Bob’s happiness as it pertains to having less money, but a better work environment. Or, if being less happy at work and having more money is worth it. Simply put, we want to know what Bob truly values. This simplistic concept is the linchpin to financial planning. If an individual/family can truly understand what they value, their financial health and well-being is easier to maximize. Every decision can then be based on core principal tenants allowing you to optimize your money. For example, let’s say Bob truly valued travel, to the point that every trip he could go on would bring joy[4], that he felt, was truly “Priceless”. Knowing that, we can begin to make the optimal decision. Based on his feeling towards travel, one could argue that Bob should stay at his current job, allowing him to travel and maximize his utility. Understanding what you truly value allows you to take control of your dollar and begin spending it in a way that maximizes your happiness, regardless of what that might be.

If we were to achieve this level of understanding, the financial planning process becomes an easier road. For example, budgeting becomes less of a task. Let’s assume clothes make you happy and feel great, but your cable subscription and going to the movies is, well, blah. Now you know – cut your cable and stop going to the movies, freeing up cashflow for shopping. Furthermore, when hit with a large event such as a job change, increase or decrease in income, or divorce, the opportunity costs you face become simplified as you know where to start decreasing, increasing, or adjusting. With that said, what you value can change over time; if you recognize the change, then you can begin making the necessary moves to reach optimization. Understanding what you value can allow someone who makes $40,000 per year feel like the richest person in the world, as they can truly maximize the value of their dollar achieving what they truly want.

I recognize it is easy to sit here and write about how the secret to financial success is understanding what you value. It is not an easy task and it’s constantly changing, but I do have a real-life example to possibly help you figure out what you value. When I was roughly 10 years old my family went on vacation to Hawaii. I saved up all my money from birthdays and working with my Dad, and I was going to buy a souvenir. We got to Hawaii and seven days later, back in the LAX airport, I cried to my mom explaining how distraught I was that I didn’t buy a souvenir. At that point, I didn’t realize that stuff didn’t bring me happiness. Fast forward to my senior year in high school and a trip to California. Before my friends and I left, I had won a competition at school that layered my pockets with about $400. On our trip, I took that $400 and bought dinner for all my friends and didn’t even blink an eye. You see, I don’t value stuff, I value seeing other people enjoying themselves and I enjoy people’s company. This is where my dollars are spent, not because it’s cheaper, but because my dollar goes a lot farther when I spend it on experiences with others. If you can look back at your past and see where you felt the most joy when you spent your dollar and maybe a few times you had remorse, you can begin to understand what you value.

There is no such thing as a free lunch and this simplistic phrase unleashes a hundred different ways on how to look at spending money. It is difficult to evaluate every situation to maximize your dollar – you could go mad. However, taking the steps to understand that, 1) opportunity cost is real and is a constant battle you’re in, and 2) reflecting on what you truly value, will allow you to begin optimizing your money placing you in the driver’s seat of your financial well-being.

[3] In this example, I am not including taxes, benefits, time value of money, or other items to simplify the example. If you are currently in a similar situation, please note there are other considerations that need to be taken.

​When a family or individual approaches us to begin assessing their ability to retire and live on a fixed income, we explain that financial planning comes down to a simple equation: income (I) – expenses (e) = free cash flow (FCF). Where things become subjective and more complicated is the composition of I and more specifically E. A subjective piece to E, is the rate at which it is increasing over time, otherwise known as inflation. One metric used to describe inflation is the Consumer Price Index (CPI)[1], which measures the rate of change for a basket of goods and services purchased by households. CPI is a general indicator of the rate at which E is increasing over time. The issue – not every E category is inflating at the same rate. Furthermore, each E category has a differently weighted percentage relative to E. Meaning, averaging CPI over time and applying that percentage across all E categories may produce results that are not indicative of the future. To produce a more accurate picture, you must understand the amount you will be spending for each E category and then apply an appropriate inflation rate[2]. Moving forward, one E category one must truly understand is healthcare.

The U.S. healthcare system has been front and center for most Americans in recent years and rightfully so, as it affects everyone regardless of their economic status. There are endless debates if our system is broken or not, and what should or should not be done to get it fixed. However, it seems both sides can agree on one thing – the cost of care is increasing at an unsustainable rate. In addition, the percentage amount spent on healthcare is increasing relative to E, slowly moving its way into the discussion as a “game changer” as it pertains to E while in retirement. This is evident in the chart[3][4] below.

​Individuals are spending more on healthcare as they enter their later years. Logically, this makes sense, as we tend to need more medical attention as we age. In comparison, three of the remaining four categories decrease as we age, lessening the overall impact to our E.​Furthermore, the inflation rate of healthcare is roughly 2% higher than food and beverage, housing, and transportation. The difference in inflation may seem miniscule; however, it’s not, as seen below[5].

At the end of 10 years, you would be spending almost $3,000 more per year in healthcare costs. If you assumed you were 75 at the end of the 10-year period, were going to live another 10 years, and held the cost of healthcare constant, you would pay, roughly, an additional $28,000 more in healthcare due to a 2% difference in the inflation assumption. And to make matters worse, pundits believe the total cost of Medicare will increase 6.5%[6] per year – 1.6% higher than the average cost of healthcare!

Now that we understand the impact of healthcare cost to our overall E, what can a family or individual do to help mitigate some risk?

Utilize qualified vehicles such as a Health Savings Account (HSA).An HSA is a powerful vehicle to use when planning for medical expenses pre- and post-retirement (you can re-read our May 2016 blog post titled HSA’s, FSA’s, HRA’s…“Whoop-de-doo! What does it all mean, Basil?” for further information). If you are currently retired and on Medicare you are unable to contribute to an HSA. However, if you have an HSA balance, you can use it for any qualified medical expenses. If you are not retired and your current healthcare plan qualifies you to contribute to an HSA, you could fully fund the account until you are no longer allowed to, and then utilize it while on Medicare to help cover some unknown costs in retirement. It is a great vehicle to help mitigate future increases in cost.​Understand each part of Medicare and what it covers, then fill in the gaps with supplemental insurance (Medigap policy).Understanding what Medicare Part A, B, C, and D all cover is important because they most likely will not cover all medical costs. To fill the gap, you may buy what is referred to as a Medigap policy. This policy is meant to fill the holes in which Medicare leaves. This will help mitigate out of pocket expenses you may incur while in retirement. Moreover, your premiums will increase over time, as explained above, but it is easier to predict the rise in premiums then having to pay out of pocket for an unexpected event for which you were not covered. We would highly suggest you work with an independent insurance broker who can help facilitate quotes and provide customized advice on how you should be covered. Please note, every family or individual has different circumstances – what works for your neighbor may not work for you.

Understand the future cost of healthcare and plan appropriately.Understanding the future cost of healthcare and the amount you may spend is paramount. With the assumption that costs can change, as they are highly unpredictable, being conservative with your inflation rate and spending assumptions will help stress test your scenario, allowing you to plan for future costs. In addition, continually reviewing these assumptions and adjusting accordingly will help with the ever-changing landscape of healthcare costs.

Healthcare is on the rise and until there are changes to our current healthcare system, plan on this being an issue for the foreseeable future.

How LBW Sees It

At LBW we typically take a contrarian view as it pertains to our industry – it’s built into our culture. However, performance chasing[1], and the potential harm it can cause, is a subject where sticking with the crowd seems best. Instead of going into a boring definition, here is a quick exercise. Please read the following passage:

Often, we are asked “How are the markets doing?” – well, they aren’t doing too shabby this year. Year-to-date (“YTD”) the S&P 500 is up 12.53%[2], the Russel 3000, up 13.91%[3], and the MSCI World ex USA, up 19.31%[4].

What were your thoughts? Did you immediately think “Did I have exposure to the MSCI World ex USA index? If not, is there a way to participate?” At the very least, the almost 20% YTD return from the MSCI World ex USA index must have caught your eye. The subconscious gravitation towards the highest return number is the starting point of performance chasing and can cause people to chase one excellent return after another. It has been highly researched and the negative effects are cause for concern. For example, Morningstar[5], a well-known investment research and analytics company, ranks funds by stars – five indicating the best and one indicating the worst. Plenty of research has been done arguing the validity of the rankings and the strategy of buying five-star funds versus other-star funds. Most of the findings come to the same conclusion – past returns are not an indication of future results. Simply put, the rankings are a better marketing tool than a fund selection tool.

Performance and rankings are not the only metrics where evidence of performance chasing can be found. In the past few months we have blogged about cannabis and cryptocurrency due to the sheer number of conversations with others revolving around the future return and growth potential cannabis and cryptocurrencies (bitcoin in particular) may have and our thoughts on how to partake in the future gains. They asked because they saw headlines like “Arcview projects the legal marijuana market will hit $20.6 billion in revenue by 2020, up from $5.4 billion in 2015”[6] or “Cryptocurrency Hedge Fund Returns 2,219%”[7] or “No wonder investors are rushing into cryptocurrencies – average ICO returns are 1,320%”[8]. Even in our blog post “And the PLOT thickens…”[9], we discussed the potential growth runway for the cannabis industry and argued that because the total addressable market (“TAM”) is so large, it causes individuals to flock to the industry in the attempt to hit the next perceived gold rush.

Examples of performance chasing are almost limitless and the common denominator seems to stem from the very definition “Entering or exiting of a trend after the trend has already been well established”[10] (emphasis LBW’s) – trend following. The market place is a zero-sum game making trend following difficult. To effectively execute this type of strategy, one must anticipate an event or catalyst no one, or few people know, is going to occur. For example, the housing crisis of 2008, only a few recognized the inevitable defaults on waves of home mortgages creating a credit crisis that spiraled our economy into the Great Recession. If everyone had a crystal ball and could predict the future, the Great Recession may have never occurred. Furthermore, Ray Dalio, arguably one of the best hedge fund managers of all time, in the early 1980s correctly forecasted the Latin American debt crisis but misjudged its impact on the U.S.[11] Mr. Dalio’s misplaced bet almost sank his fund. We are not positing that Mr. Dalio follows trends, but that even with his in-depth understanding of complex ideas, he sometimes struggles to predict the future. So, why would chasing returns, rankings, or even TAM be any better?

Our society is geared towards basing our decisions on a simplification of complex ideas. We want information handfed to us with little to no effort, but as my high school football coach would say “If it was easy, everyone would do it.” If investing was simply following performance, rankings, or TAM, we would all be rich and we wouldn’t have to write about chasing these metrics. Our point, chasing performance is like going into a casino, watching someone hit a jackpot on a slot machine, and then sitting down at the same machine assuming you will hit the jackpot as well. Trends have their place; however, when they become a metric to base a decision upon, they are nothing short of dangerous. At LBW we are mindful of trends, but do not allow them to dictate our investment decisions. Our goal is to read and perform in-depth research on areas we feel our competence lies. This allows us to understand what we own and examine the risk versus reward and invest as we see fit. We would rather hit singles and doubles every day instead of swinging for the fences and hitting a home run once every ten at bats. Taking the time to truly understand the risk versus reward in any opportunity is not easy and does takes time, but it typically produces the best results.

Nathaniel's Beautiful Mind

The Four Filters

As I was trying to figure out what to write about this quarter, I reviewed past commentaries. In doing so, I realized I had never written about the four filters that comprise our investment framework. I can assure you this isn’t by design; it’s not as if they are a trade secret. They are in fact quite well-known throughout the investing community. They are, in ascending order:

1.Do I understand what the company does?2.Does the company have a sustainable competitive advantage?3.Does management focus on strong capital allocation and maximizing shareholder value?4.Can I purchase the company (or security) at a Margin of Safety?

These filters were conceptualized by Warren Buffett and Charlie Munger, and allow an investor to thoroughly and efficiently dissect a company or security[12] in their determination of whether it’s a worthy investment or not. You may ask, “Why four filters?” or “Why are they so simplistic?” I would argue that the filters are meant to be overarching concepts that can be applied in various ways. As you can see, these filters are posed as questions that appear to be very simple on the surface, when in fact, there can be a great deal buried beneath. Alternatively, the filters are structured such that if I’m being honest with myself, I can be quick to answer them. As I get older and gain more experience, the end goal is to utilize these four filters to make sound investments and avoid unprofitable mistakes.

Some BackgroundIn the beginning of my value investing education, I subscribed to Value Line’s Investment Survey using the discounted 13-week trial. I went out and bought a printer, and proceeded to print off every issue for the next 13 weeks. I then read every single one-pager on all the companies covered. It was a safe bet to assume that the majority of the covered companies wouldn’t change for a year, so I held on to my printouts to review throughout the year, and waited to do the 13-week trial the following year. I got smarter the second time around, and just downloaded the PDFs and read them on my laptop. I continued this process for virtually the next ten years in various forms. Over the years, my knowledge compounded as I learned about as many companies as I could get my hands on. I began to construct mental models[13] based upon the numbers and business profiles I read that helped me to quickly siphon through companies. Eventually, it got to the point where I could get through an entire issue in less than a half hour. The point of this exercise was to use Value Line’s survey as a jumping-off tool to further dig into companies that caught my eye. This process then led to a further compounding of knowledge as I learned of the four-filter framework in my readings of Charlie Munger, and proceeded to apply it in my in-depth research of those selected Value Line ideas. In some cases, the research didn’t lead to a buying of the company’s security, but I learned a great deal about the company’s economics or moat or lack thereof that could be applied to another company within the same industry or I shelved the pertinent security until it’s price reached a discount to my estimate of its intrinsic value[14].

Do I understand what the company does?Warren Buffett is fond of repeating a quote attributed to Thomas J. Watson, Sr., founder of IBM: “I’m no genius. I’m smart in spots—but I stay around those spots.”[15] One of the major rules I have is not investing in companies I don’t understand, that is, companies that are outside my circle of competence. If I don’t understand what the company’s product or service is or does, or I don’t understand how the company earns its revenues, then I won’t invest in it. As an example, pursuant to my circle of competence, I don’t feel comfortable investing in a company like Gilead Sciences because I don’t know the first thing about drug trials or anything about the drugs Gilead produces and what those drugs do. Sure, I could take a crack at learning about Gilead, but I know based on skimming over Gilead’s 10-k[16], that I simply don’t have a comfortable understanding of Gilead’s business. With that said, Gilead would not pass the first filter, and would go into the “too hard” pile. I have found over the years that I am becoming more and more comfortable saying “no” to something that I don’t understand – I don’t have to invest in every potential opportunity that comes my way.

Does the company have a sustainable competitive advantage?If I understand what the company does, I can then determine if the company has a moat. What is a moat? A company can have multiple moats and a moat is typically classified in one of the following categories: low-cost producer, high switching costs, network effect, and intangible assets. The moat(s) can usually be determined from the company’s financial statements and more specifically certain metrics like gross margin, operating margin, net income margin, free cash flow (FCF) margin, cash return on invested capital (CROIC)[17], incremental cash returns on invested capital (InCROIC), and reinvested FCF. Some of these metrics should be compared against their industry peers like operating margins while others are more relevant on an absolute basis like InCROIC. It is highly critical that I review the company’s financials for at least a ten years’ period[18]. There are a number of indicators throughout the financials that can indicate the type of moat such as “Does the company have negative working capital (current assets are less than current liabilities)?” If yes, they are likely a low-cost producer like Walmart. Due to Walmart’s scale and high sales turnover[19], they are able to collect their receivables faster than they pay their vendors, hence a negative working capital balance.

Once I’ve determined the company’s moat(s), I study its competition and determine if its industry is experiencing any secular trends. Are there any competitors that could threaten the company’s moat? Are there any secular trends acting as tailwinds or headwinds? If so, can I conservatively estimate when the moat may disappear? Alternatively, is the moat growing? Can I forecast how much the company will earn for the next ten years? As an example, let’s take Pepsi-Cola. Pepsi’s moat is based upon an intangible, its brand[20]. Over decades, Pepsi has invested in their brand by spending billions on marketing. They and Coca-Cola[21] maintain a semi-comfortable duopoly, and have a relatively stable moat. What could breach this moat? Today, there are concerns about health and nutrition, and as a result, both Pepsi and Coke have had some headwinds to their respective moats from this secular trend. Pepsi has responded by investing in and adding healthy alternatives to its portfolio of beverages and snacks like organic Gatorade or lowering salt levels in its snacks. Have their investments paid off? The answer can be found in many of the previously-listed metrics as well as asking people what they feel when confronted with Pepsi’s brand (to those who want to know, yes, they’ve done a good job so far).[22] If after determining the company’s moat and stress-testing it, and if I think the company’s moat will be around for at least ten years if not longer, then I move onto the next filter.

Does management focus on strong capital allocation and maximizing shareholder value?As I have mentioned in previous commentaries, I place heavy emphasis on management who act like owners, otherwise known as owner-operators. When there are owner-operators at the helm, the odds increase dramatically that shareholder value is being built. To be on the safe side, I want to review management’s capital allocation track record using at least the same period’s financial statements, if not longer, from the second filter’s process.

Management typically have five possible avenues to allocate capital and create shareholder value:

Metrics used to determine management’s record of utilizing the above avenues include ROIC, return on equity (ROE), return on assets (ROA), return on retained earnings (RORE), and CROIC. As you can see, some of these metrics can be applied to multiple filters. The core question you want answered is, “For every dollar of capital invested, is the company generating greater than one dollar in returns?” For our purposes, let’s use a simplified example: if a company earns $1 FCF and management chooses to reinvest that $1 back into the business and the reinvested capital produces 20% annual returns, management has successfully created shareholder value because for the one dollar invested, 20 cents is produced.

In addition to measuring management’s capital allocation record, I also like to read quarterly and conference transcripts and investor letters to see if management is holding themselves accountable to statements that they have made in the past. You can gain a good understanding about management from such sources, especially over long periods of time. Once I have determined that management has exhibited a strong capital allocation record and maximized shareholder value, I can move onto the fourth and final filter.

Can I purchase the company (or security) at a Margin of Safety?If a company has passed all three of the prior filters, we come to the most important filter of them all. This is a concept that we speak of daily amongst ourselves, with you our clients, and in our past commentaries. I would be willing to call this concept the bedrock of our investing framework. A typical company’s common share market price experiences high levels of volatility throughout the year. However, it’s intrinsic value, what I believe the security to be worth, experiences far less volatility than its market price. My job is to purchase a security at a substantial discount to its intrinsic value. The difference between the two is known as the “Margin of Safety” (MoS) (Intrinsic Value – Purchase Price = Margin of Safety). The MoS allows for imprecision, analytical error, or systemic risk in my intrinsic value calculations. In essence, the MoS acts as a barometer of my comfortability with my analysis of the company / security and of the industry in which it operates, and can determine a security’s concentration across our clients’ accounts. If I am not too comfortable with my analysis, I may assign a larger MoS to the security, say 50%, versus a security’s analysis that I may be more comfortable with, like 25%. If the security is trading at a large discount to my intrinsic value estimate, I’ll buy it. If not, that doesn’t mean that I’ll forget about the company / security. Instead I’ll add the company / security to my monitoring list, from which I will keep tabs on it, and will buy it if the opportunity were to present itself.

ConclusionAs I stated previously, these filters are well-known throughout the industry. The secret to investing is not the filters themselves, but the interpretation and execution of them. It is critical that an investor create processes around the filters that work best for them. There is no one set path; this is the framework that works best for me. Ultimately, when the filters are utilized in a rational manner, an investor is far more likely to succeed in not only making profitable investments, but also in omitting investment mistakes.

[12] Companies may have multiple securities based upon them. These include common stock shares, preferred shares, bonds, rights, and warrants. All of these security types have different terms, and vary in where they belong in a company’s capital structure. For this commentary, the terms “company” and “security” will be used interchangeably or in tandem as circumstances warrant.

[13] This is a concept I learned from Charlie Munger’s writings. Too much information to go into here, but perhaps we can write about them in future commentaries.

[16] Annual report that a publicly-listed company must file with the SEC.

[172] This metric is particularly important in deciding if management focuses on building shareholder value.

[18] There are exceptions like special situations or companies rising out of bankruptcy.

[19] Due to its high sales turnover, Walmart consistently buys large volumes of product. Because they buy such large volumes, Walmart can use this as leverage to stretch out their payables to their vendors.

[20] This isn’t Pepsi’s only moat. They also have an incredible distribution system and economies of scale.

[21] This answers the competition question. There are other competitors like Dr. Pepper Snapple Group, but Pepsi and Coke are the biggest ones.

[22] For those interested, awhile back I wrote up everything I look at when reviewing a company’s financials. It’s too long to send out with this commentary as I’ve added to it over the years, but if you’re interested, I’m happy to send out copies upon request.